Global equities advanced in the third quarter, as steady macroeconomic growth supported solid earnings reports. In the evolving market environment, we believe that individual company performance will make a bigger difference to stock returns.
Equity investors have had plenty of reasons to cheer this year. The MSCI World Index advanced by 3.9% in the third quarter (Display, left), to return 12.5% this year, in local-currency terms. Escalating geopolitical tensions between the US and North Korea hardly dented the positive sentiment toward stocks.
Resources stocks outperformed as oil prices rebounded (Display above, right). Emerging-market (EM) stocks outpaced developed-market equities. European market gains lagged in July and August after a strong first half, as investors became concerned that the appreciating euro would hurt exporters even as it signaled confidence in the region’s political stability. But stocks in the region rebounded in September as the US dollar strengthened.
US large-caps did well, fueled by Facebook, Netflix, and other so-called FAANG stocks, which accounted for more than 20% of the S&P 500 Index returns this year. Their popularity has helped fuel returns for growth stocks, which have outperformed value stocks by a wide margin in the first three quarters of 2017.
Emerging Markets Earn Investor Confidence
The recovery of emerging markets is one of the most important developments for equity investors in 2017. In the first nine months of the year, the MSCI Emerging Markets Index has advanced by 24% in local currency terms—nearly twice the performance of the MSCI World Index.
Talk of rising US interest rates hasn’t derailed EM equities. Unlike the “taper tantrum” in 2013, which hit EM stocks hard, concerns about rising rates have passed over the developing world. Emerging markets are less vulnerable to external shocks than in the past. Increased foreign direct investment means that emerging markets are less reliant on funding from shorter-term portfolio flows, which are more prone to flight. Currencies are more competitive and short-term debt levels have declined. These trends reduce the vulnerability to external shocks, such as rising US interest rates.
But domestic macro improvements are really only part of the story. EM equity gains are actually being driven by a consistently improving earnings outlook. Consensus expectations project a 30% increase in earnings per share for EM companies over the next two years. That said, industry outlooks vary widely in emerging markets—and volatility can be acute—so it’s especially important for investors to take a highly selective approach and focus on individual stocks with the strongest potential.
Goldilocks Economy Supports Global Earnings
Developed-world stocks have also been helped by optimism about the outlook for corporate earnings. Our portfolio managers meet regularly with the managements of companies around the world. These days, we often hear that a comfortable macroeconomic environment is supporting positive business dynamics across many industries.
Indeed, global GDP is advancing at an annual pace of more than 3%, helped by a continued recovery in the euro area and Japan. It really is a global Goldilocks economy, with moderate and steady growth that hasn’t fueled inflationary pressures. This, in turn, allows major central banks in Japan, the euro area and the US to maintain relaxed monetary policies. And that’s good for stocks. For example, the US Federal Reserve’s signal in late September that it will slowly and incrementally raise interest rates has reassured investors that favorable macro and monetary conditions should continue.
Two Real Risks
But there are real risks to consider, too. First, interest rates could rise faster than expected. We believe that this is one of the key threats to equity returns that investors should consider today. Since current monetary policies have been so helpful for the equity market, we think a faster-than-expected rebound in interest rates could deliver a shock to markets. In this scenario, stocks with negative sensitivity to interest rates, such as real estate and utilities stocks, would be particularly vulnerable. On the other hand, undervalued banks and cyclical stocks could do well.
Valuations are another concern. Overall, equity market valuations are higher than usual. That said, we don’t see signs of a bubble and valuations are diverse across regions. Even after this year’s rally, we believe that EM stocks are still attractive versus their developed-market peers. In the developed world, US stocks are trading further above their historic norms, while European and Japanese stocks are somewhat less expensive.
Stock Correlations Are Falling
But here’s the good news. The positive macroeconomic backdrop has prompted a decline in stock correlations (Display). Over the last decade, we’ve seen that stocks tend to trade in the same direction as investors shift from “risk on” to “risk off” mode. Recently, stock correlations have started to decline, which signals that investors are starting to focus more on company specifics.
Why is this important? Because we live in a world of lower expected returns. Returns from stock markets in the coming years are still likely to exceed returns from bonds, but they won’t be as strong as they were in the past, according to our forecasts. In this type of environment, finding stocks that can beat benchmarks is essential for investors to meet their long-term goals. When stock correlations decline in a broadly supportive macro and market environment, we think skilled stock pickers will be increasingly rewarded for identifying companies with better business dynamics.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
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